the sale of scottishpower and hydro-electric · electricity companies in england and wales, in...

NATIONAL AUDIT OFFICE

REPORTBYTHE

COMPTROLLER AND

AUDITOR GENERAL

The Sale of ScottishPower and Hydro-Electric

ORDERED BY THE HOUSE OF COMMONS TO BE PRINTED IO JULY 1992

LONDON: HMSO 113 f6.55 NET

THE SALE OF SCOTTISHPOWER AND HYDRO-ELECTRIC

This report has been prepared under Section 6 of the National Audit Act, 1983 for presentation to the House of Commons in accordance with Section 9 of the Act.

John Bourn Comptroller and Auditor General

National Audit Office 3 July 1992

The Comptroller and Auditor General is the head of the National Audit Office employing some 900 staff. He, and the NAO, are totally independent of Government. He certifies the accounts of all Government departments and a wide range of other public sector bodies: and he has statutory authority to report to Parliament on the economy, efficiency and effectiveness with which departments and other bodies have used their resources.


Contents

Summary and conclusions 1

Part 1: The companies and the sale 6

Part 2: Achievement of objectives

Part 3: Control of costs

8

20

23 Glossary of terms

Pages

Appendices

1. Electricity industry restructuring in Scotland

2. Authorised supply areas of ScottishPower and Hydra-Electric

3. List of the principal advisers and contractors appointed by the Department

24

26

27


Summary and conclusions

1 In June 1991 the Scottish Office Industry Department (the Department), acting on behalf of the Secretary of State for Scotland, sold 100 per cent of the shares in the two Scottish electricity companies Scottish Power plc (ScottishPower) and Scottish Hydro-Electric plc (Hydra-Electric) for just under E3.5 billion, payable in two forms: nearly g2.9 billion from the sale of shares, and some SO.6 billion from the staged repayment of injected debt. In preparing the companies for the sale, the Department wrote off some El billion of National Loans Fund debt.

2 The sale was the last stage in the Government’s programme to privatise the electricity industry in Great Britain. It followed the sale of the twelve regional electricity companies in England and Wales, in December 1990, and the partial sale of the two generating companies, National Power and PowerGen, in March 1991.

3 The Scottish companies generate, transmit, distribute and supply electricity. They face competition from each other, and from other companies, for the generation and supply of electricity to customers in Scotland. Each of the Scottish companies has the monopoly of the transmission and distribution of electricity within its authorised supply area. They may also compete in the electricity generation and supply markets of England and Wales.

4 The companies were floated on the London Stock Exchange. The Department offered for sale some 1.2 billion shares at E2.40 each, payable in three instalments.

5 The Government’s overriding objective was to complete the privatisation of the electricity industry in Great Britain within the lifetime of the Parliament. Within that overriding objective, the Department sought in relation to the Scottish sale: to maximise net proceeds; to achieve a modest premium on the issue price in the period following the start of dealing; to promote individual share ownership, firstly in Scotland, but also in the United Kingdom as a whole; and to encourage share ownership by individual company customers and employees.

6 This report sets out the results of a National Audit Office examination of how far the Department achieved their objectives for the sale, and how they controlled its costs. The National Audit Office examined Departmental papers, held discussions with Departmental officials and advisers, and consulted senior executives of the two companies. The National Audit Office were assisted in their work by Hambros Bank Limited.

Achievement of objectives

7 The National Audit Office’s main findings and conclusions are:

On the overriding objective of completing the iale to timetable

(a) The Department achieved the privatisation of ScottishPower and Hydro- Electric by June 1991, selling all their shareholding in each of the companies (paragraphs 2.2 to 2.4).

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THE SALE OF SCOT’I’ISHPOWR AND WDRO-ELECTRIC

On maximising net proceeds subject to achieving a healthy aftermarket

Method of sale

I$) The Department decided to sell the companies by~floating them on the London Stock Exchange as they considered that this method of sale would best meet their objective of promoting increased individual share ownership, while maximising sale proceeds through creating competitive tension between individual, institutional and overseas investors (paragraph 2.6).

Valuation of the companies: assets

(cl The Department reviewed the bases on which the companies’ fixed assets were valued, and carried out a revaluation exercise which included identifying properties which might have significant alternative use values (paragraphs 2.10 to 2.16).

(d) The Department introduced clawback provisions on property with the aim of enabling the taxpayer to share in future gains from property disposals or deemed disposals by the companies (paragraphs 2.17 and 2.18).

Debt

(e) Both companies inherited high levels of debt from their predecessor boards. The Department sought to maximise proceeds by keeping to a minimum the amount of debt written off, while at the same time ensuring the long term financial viability of both companies. This involved a net write-off of Government debt of E417.7 million (paragraphs 2.19 to 2.25).

Profit and dividend estimates and prospects

(fJ Following intensive negotiations with both companies, the Department secured their agreement to estimates of profits and dividends for the year ended 31 March 1991 which they judged satisfactory and to positive statements on prospects for dividend growth in subsequent years (paragraphs 2.26 to 2.29).

Corporation tax losses

(gl The Department wrote off the balance of outstanding corporation tax losses, arising out of unused capital allowances, in each company, amounting in total to s505 million (paragraphs 2.30 and 2.31).

Partial or full sale

(h) The Department identified a number of factors which pointed in favour of a full sale in June 1991. The Secretary of State decided to sell all the Government’s shareholding in the companies (paragraphs 2.32 to 2.34).

Carrying out the sale

(i) In carrying out the sale, the Department adopted a number of measures first used by the Department of Energy in the sale of National Power and PowerGen.

2

THE SALE OF SCOTTISHPOWER AND HMRO-ELECTRIC

Bookbuilding

(j) Institutional and overseas investors were required to indicate, in advance of pricing the offer, how much they would be prepared to invest at a range of yields; this is known as bookbuilding (paragraphs 2.36 and 2.37).

Underwriting

(k) The Department dispensed with primary underwriting, bearing the risk themselves of failure to secure adequate sub-underwriting of the offer and of the offer being undersubscribed (paragraphs 2.38 and 2.39).

Back-end tender

(1) A proportion of shares was provisionally earmarked for offer to the highest bidders from institutional and overseas investors after the close of the offer period; this is known as a back-end tender (paragraph 2.40). Implementation of the back-end tender raised additional proceeds of ~C42.25 million (paragraph 2.51).

Pricing the offer

(m) The Department took the view that in pricing the offer at a yield of 5.1 per cent they would maximise proceeds and minimise the risk of exciting excess demand while still attaining their target premium. In deciding not to price the offer at a yield of 5.2 per cent, they accepted a greater risk that the anticipated premium might be eroded over the offer period but judged that risk to be acceptably low. The difference between selling the shares at 5.1 per cent rather than 5.2 per cent represented additional proceeds of ~!Z55 million (paragraphs 2.43 to 2.46).

Aftermarket premium

(n) The premiums at which the shares opened at the start of trading were within the Department’s target range of 5 to 10 per cent of the full offer price, equivalent to 12 to 24 pence. On the second day’s dealing ScottishPower’s shares fell just below the bottom end of the target premium range, closing at a premium of 10.5 pence. They traded mostly below that premium for some months after the sale. Over the same period, Hydro-Electric shares traded mostly at higher premiums. In the six months following the close of the first day’s trading, the share prices of both companies reduced relative to the electricity sector and to the market as a whole and, whilst mostly remaining above the offer price, moved below the aftermarket target premium range (paragraphs 2.52 and 2.53).

On promoting increased individual share ownership

Incentives for individuals

(0) In order to avoid adverse media comment and the risk of an unsuccessful sale in Scotland, the Department offered customers of the two companies equivalent payment terms and incentives to those offered to customers of the regional electricity companies (paragraphs 2.60 to 2.62).

Incentives for employees

(p) Incentives offered to employees were in line with those offered to employees in the other electricity sales which represented a higher return than incentives offered in certain other past privatisations (paragraphs 2.63 to 2.66).

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THE SALE OF SCOTTISHPOWER AND WDRO-ELECTRIC

Target subscription levels

(q) The Department met their target for subscription levels (3 to 4 times the initial public offer) from individual investors (paragraph 2.67).

Share allocation

(r) 10.3 per cent of the shares offered to individuals were allocated to company employees and pensioners. Customers investing in their supplying company were allocated 35.6 per cent (paragraph 2.70).

Share retention

(s) 67 per cent of individual shareholders in both companies had retained their shares at 31 December 1991. This is higher than in the two previous electricity sales over comparable periods (paragraphs 2.72 and 2.73).

(t) 81.2 per cent of customer, employee and pensioner shareholders still retained shares at the end of December 1991. It seems likely that this relatively high overall level of retention was influenced by low premiums, and that low premiums generally made it profitable only for those with large allocations to sell. Disposals have been highest among those allocated most shares. By the end of March 1992, the number of individuals continuing to hold more than 2,000 shares (employees and pensioners only) in ScottishPower had reduced by 78 per cent. The corresponding figure for Hydro-Electric was 50 per cent (paragraphs 2.72 to 2.78).

(4 The Department have not conducted any research into individual investors’ reasons for retaining or selling their shares. In the view of the National Audit Office, such research in the period immediately following the sale might have provided useful information on key factors influencing individuals’ buying, selling and retaining decisions which might also be of assistance to departments planning future sales. The Department argue, however, that it would be a matter for departments planning future sales to carry out any such research if this were thought to represent good value for money (paragraphs 2.73 and 2.79).

Controlling the costs of the sale

8 The National Audit Office’s main findings and conclusions are:

Financial control and project management (a) The Department prepared a detailed project plan and followed appropriate

procedures in their appointment of advisers (paragraphs 3.2 to 3.4).

Marketing

(b) The Department focussed their marketing campaign on potential investors who would best meet their sale objectives. They were aware of the danger of encouraging too much demand during the offer campaign and cut back on advertising when the target level of registrations had been achieved. As a result of this and other economies they achieved savings of around El.2 million by comparison with their original marketing budget (paragraphs 3.5 to 3.14).

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General conclusion 9 The Department carried out the sale of the companies on favourable terms for the taxpayer, securing proceeds which were as high as could have been expected. The decision to proceed with a 100 per cent sale took account of the fact that the sale was taking place in a sector already established in the market, using pricing techniques that had been successfully applied in the previous electricity sale, and in favourable market conditions. For the first few months after the sale, one of the two companies traded for the most part within the Department’s target premium range; the other fell just below the bottom end of that range on the second day’s trading and mostly traded at lower premiums thereafter.

10 The Department met their target for subscription levels from individual investors and were able to allocate a large proportion of the issue to individual investors, particularly to customers, employees and pensioners of the two companies. Overall, share retention levels have been higher than in the two previous electricity sales but there have been significant disposals by those individuals who were allocated the most shares.

Recommendations 11 In the National Audit Office’s view departments should, when pursuing objectives set by the Government in relation to future sales:

. continue to build on the innovations successfully introduced in this and in the previous electricity sale;

. continue to set appropriate targets by which they can monitor, appraise and influence progress towards achieving their objectives for the sale;

l continue to evaluate the contribution incentives might be expected to make towards achieving sale objectives including their possible impact on share retention; and

. carry out market research to establish why individual investors bought, sold or retained shares.

5


Part 1: The companies and the sale

1.1 In June 1991 the Scottish Office Industry Department (the Department), acting on behalf of the Secretary of State, sold 100 per cent of the shares in the two Scottish electricity companies Scottish Power plc (ScottishPower) and Scottish Hydra-Electric plc (Hydro- 1.4 Electric). In preparation for the sale the Department wrote off some fl billion of outstanding National Loans Fund debt. Gross proceeds from the sale will eventually amount to just under s3.5 billion: nearly fX?.S billion from the sale of the shares and seme fo.6 billion from the staged repayment of injected debt. Figure 1 sets out the gross proceeds and the overall timetable for payment.

Figure 1: Gross proceeds

E million Sale of equity by instalments

June 1991 May 1992 Apri 1993

Equity proceeds (Figure 8)

Debt repayment varying instalments until 2005 :

1,211 822 822 -

2,855

626 3 c

Gross proceeds I.il

3,481

Source: Scottish Office Industry Department

his Figure shows the estimated gross proceeds from the sale and the timetable for payment.

1.2 This sale was the last stage in the Government’s programme to privatise the electricity industry in Great Britain. It followed the sale of the twelve regional electricity companies in England and Wales, in December 1990, and the sale of the majority of the Government’s shareholding in the two generating companies, National Power and PowerGen, in March 1991.

1.3 The sale was preceded by the restructuring of the Scottish electricity industry. Under the new structure, which came into effect on 31 March 1990, ScottishPower and Hydro-Electric were created primarily out of the South of Scotland Electricity Board and North of Scotland Hydro- Electric Board respectively. Following the Government’s decision in November 1989 to retain the Scottish nuclear industry in the

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public sector, the nuclear and nuclear related assets and liabilities of the old boards were transferred to a new company, Scottish Nuclear Ltd.

ScottishPower and Hydra-Electric face competition from each other, and from other companies, including the clcctricity cornpanics in England and Wales, for the generation and supply of electricity to consumers in Scotland. Each company has the monopoly of the transmission and distribution of electricity within a specified geographical area known as the authorised supply ama. They may compete in the electricity generation and supply markets of England and Wales. Both ScottishPower and Hydro-Electric are obliged, under the Nuclear Energy Agreement, to take electiicity from Scottish Nuclear until April 2005. The main features of the restructuring of the Scottish electricity industry are summarised at Appendix 1. Appendix 2 shows the approximate locations of the authorised supply areas of ScottishPower and Hydra-Electric.

ScottishPower and Hydro-Electric were offered for sale, by means of a flotation on the London Stock Exchange, to individual and institutional investors in the United Kingdom and Overseas investors. The offer was at a fixed price except for 16 per cent of the shares which were sold by tender to institutional and overseas investors.

The Department offered for sale some 1.2 billion shares. The fixed price offer was at a price of f2.40 for each share, payable in three instalments: fl on application, 70 pence in May 1992 and 70 pence in April 1993. Bids in the tender secured on average a premium of 23 pence.


Objectives for the sale Scope of the National Audit Office examination

1.7 Within the Government’s overriding objective to complete the privatisation of the electricity 1.8 The National Audit Office examined: industry during the lifetime of the Parliament, the objectives for the sale of the Scottish (a) how far the Department had achieved the companies were: sale objectives (Pact 2 of Report); and

subject to market conditions, to transfer them to the private sector through a simultaneous public offer for sale no later than June 1991;

to maximise the net proceeds of sale subject to:

(il the achievement of a healthy aftermarket;

[ii) the promotion of increased individual share ownership, firstly in Scotland but also in the United Kingdom as a whole, consistent with the sales of the electricity supply industry in England and Wales: and

(iii)& encouragement of share ownership by individual company customers and employees.

(b) how the Department controlled the costs of the sale (Part 3 of Report).

1.9 The National Audit Office reviewed how the Department planned and carried out the sale, and the outcome. This work included an examination of Departmental papers and discussions with Departmental officials and their principal external advisers. The National Audit Office also consulted the Chairman and senior executives of Scott&Power and the Chief Executive and Finance Director of Hydra-Electric. The National Audit Office have obtained advice from Hambros Bank Limited. The National Audit Office are grateful for the help they have received in carrying out this study and producing their report.

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2.2

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2.4

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Part 2: Achievement of objectives

This part of the report examines how far the Department were successful in achieving their sale objectives:

[a) to complete the sale to timetable:

(bl to maximise net proceeds subject to

(i) achieving a healthy aftermarket

(ii) and [iii) promoting increased individual share ownership.

Objective (a): completing the sale to timetable

The Government’s overriding objective was to complete the privatisation of the electricity supply industry in Great Britain within the lifetime of the Parliament. The sale of ScottishPower and Hydra-Electric was preceded, in December 1990, by the sale of the twelve regional electricity companies who distribute and supply electricity in England and Wales and, in March 1991, by the partial sale of National Power and PowerGen, who generate electricity in England and Wales. I have separately reported on the sale of the twelve regional electricity companies in England and Wales (HC 10 of Session 1992-93) and of National Power and PowerGen (HC 46 of Session 1992-93).

The Department aimed to carry out the sale of ScottishPower and Hydro-Electric by June 1991, this being the earliest feasible date following the sale of National Power and PowerGen in March 1991.

outcome

The Department completed the sale of the Scottish companies, which were sold in their entirety, by their June 1991 target.

Objective (b)(i): maximising nei proceeds subject to achieving a healthy aftermarket

The National Audit Office examined whether the Department had:

identified the most appropriate method of sale, consistent with their other objectives;

valued the companies by reference to the most appropriate criteria;

considered ways in which a proportion of any value not identified at the time of the sale might subsequently be recovered through suitable clawback provisions;

negotiated with the companies appropriate debt arrangements, together with profit and dividend estimates and prospects: and

carried out the sale on the best possible terms for the taxpayer, including identifying an appropriate target range of premiums, consistent with their objectives, drawing where appropriate on the experience gained from previous privatisations, notably the sales of the electricity companies in England and Wales.

Method of sale

2.6 The Department decided that, having regard to their objective of promoting increased individual share ownership, the most appropriate method of sale would be the flotation of both companies by a public offer of fixed price shares open to individual, institutional and overseas investors. Offering the shares to these three groups was also intended to give rise to competitive tension between them, thereby maximising sale proceeds.

Valuation of the companies: dividend yield

2.7 When a utility is floated on the stock exchange, the basis on which it is normally valued is the expected stream of future dividends to shareholders. This is known as the yield. This was chosen by the Department as an appropriate basis on which to value the two companies. This basis had been adopted by the Department of Energy for the previous electricity sales.

8

THESALEOFSCOTTISHI'OWERANDHYDRO-ELECTRIC

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2.9

2.10

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Yield is usually expressed as a percentage, representing the proportion of the gross dividend to the share price. Companies commanding low yields are typically those which ape seen by investors as offering good growth potential and/or low risk. These judgements also take account of how investors view the prospects of other companies, since they are in competition for investors’ funds with the company being sold. The yield demanded by investors is also influenced by factors extraneous to the company, in particular interest rates and, more generally, prevailing levels of confidence in the market.

For a given dividend, the lower the yield acceptable to investors, the greater will be the value of the shares and hence the proceeds from the sale of the company. Conversely, the higher the yield required by investors, the lower will be the proceeds.

Valuation of the companies: assets To confirm the value of the companies’ assets, the Department, jointly with both companies, appointed valuers in December 1989 to carry out a revaluation exercise. The Department were particularly concerned to identify any surplus assets or any with a potentially higher value for some alternative use.

The bulk of the companies’ fixed assets consisted of land, buildings and equipment of a specialised character, relating to the generation, transmission and distribution of electricity. Such assets included power stations. Most of the remaining assets consisted of non-specialised property, assets under construction and miscellaneous machinery.

The valuers reviewed all specialist sites in order to identify property with significant alternative use values and any surplus property. Eleven sites were identified with potential alternative use values in excess of fl million each.

Non-specialised property, including offices, shops, depots, land reserved for new power stations, surplus property and property held for investment purposes was valued on the basis of the price it might command on the open market. The Department also instructed the valuers to identify any such property which they considered would have a significant alternative use value, and to quantify that additional value.

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2.15

2.16

2.17

The valuations arising out of this review were subject to a further review in December 1990. This further review, which focussed on non- specialised property, resulted in a net downward adjustment which reflected the general fall in the property market since the first revaluation exercise.

The Department made special arrangements for land previously identified for possible future power stations at Torness, Portencross, Chapeldonan and Stakeness. Each of these properties was judged to be surplus to the requirements of the companies. As at 31 December 1989 the four properties had an estimated combined open market value of some f1.4 million. The Department decided to transfer the ownership of these properties to Scottish Nuclear so that gains from any future disposal would accrue entirely to the public sector.

The Department’s revaluation exercises resulted in an increase in the fixed asset values of ScottishPower and Hydro-Electric of f38 million andf6.4 million respectively, as against pre-revaluation historic book values. The sale prospectus set out the value of each company’s fixed assets on the historic cost basis (original cost less depreciation) and on an abridged current cost basis (replacement cost less depreciation). On the historic cost basis this amounted to some ~51.8 billion, and on the abridged current cost basis some f4.8 billion. The historic cost basis is the one on which the accounts of the companies had been prepared in the past and the one on which the directors of both companies intend to prepare annual accounts in the future.

Clawback provisions

The Department considered the case for introducing clawback provisions on property sales to enable the taxpayer to share in any gains arising from future property disposals by the companies which it had not been possible to identify at the time of the sale. Following the transfer of some surplus property to Scottish Nuclear, and having identified only limited alternative use values for property owned by the Scottish companies, the Department considered that the benefits that might accrue to the taxpayer as a result of such a provision were likely to be small. By the same token, however, they concluded that the inclusion of property clawback provisions was unlikely to have a detrimental effect on the dividend yield at which the companies would be sold.

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2.18

2.19

2.20

2.21

The clawback provisions apply to any disposal or deemed disposal by the companies of individual properties owned or leased at vesting, in the period to 31 March 2001. Under these provisions, gains in excess of f325,OOO will trigger clawback and the provisions will apply to the whole of the gain, which will be shared equally between the taxpayer and the company concerned after deductions for corporation tax and costs. The gains subject to clawback will consist of any additional value realised above the existing use valuation at 31 March 1991 or, in the case of non-operational property, the historic cmt. So far there have been no receipts from clawback. No clawback will apply to disposals or deemed disposals of specialised property to a purchaser who continues de existing operational use of the property until 31 March 2000.

Negotiating the sale: debt

At vesting both companies inherited substantial levels of National Loans Fund debt from their respective predecessor boards. Prior to flotation, the outstanding loans totalled f1,043.6million,amountingtof508.7millionin ScottishPower and f534.9 million in Hydro- Electric. As the National Loans Fund cannot lend to private sector companies the Department wrote off all these debts.

To maximise proceeds from the sale, the Department then sought to have an appropriate pact of their investment in the companies represented by new debt at flotation. This required the injection of new debt into the companies for which the companies received no cash. The debt attracts market rates of interest. Whether or not the injection of new debt maximises total proceeds depends on a judgement as to which is the higher:

(a) the proceeds from repayment of the principal sum of the debt; or

@I the additional equity proceeds that might be realised from the sale if that amount of debt was not introduced.

Proceeds tend to be maximised by the injection of a sustainable level of debt. Servicing debt capital out of any given level of profits is normally cheaper to a company than servicing equity capital. There are two reasons for this. First, interest on debt is tax deductible, while dividend payments are not. Second, dividends usually increase with time, which is not normally so in the case of

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2.25

interest, which, if not fixed, will nmve only in accordance with general interest rates. At higher levels of debt, however, sale proceeds are likely to decline. This is because the costs of servicing debt beyond certain levels are likely to be perceived by investors as unacceptably high in relation to earnings and a risk to the ability to pay dividends.

In floating the companies, the Department, therefore, had to have regard to the maximum amount of debt that the companies could bear without endangering their ability: to meet interest payments: tn repay the debt when it became due; to pay dividends; and to provide for future investment.

The proportion of a company’s debt to its equity is normally referred to as its gearing. The Department were advised that, having regard to the relative nature and size of each company’s operational assets and competitive position, the gearing of Hydra-Electric should be smne 5 to 10 percentage points lower than that of ScottishPower. The Department’s advisers concluded that gearing in the range of 40 to 50 per cent for ScottishPower and 36 to 45 per cent for Hydra-Electric would maximise proceeds, subject to interest payments being covered at least four times by profits. Following intensive negotiations with the companies, agreement was reached on levels of debt which implied gearing of 48 per cent for ScottishPower and 43 per cent for Hydro-Electric, assuming inclusion of the revised fixed asset values noted in paragraph 2.16. The f38 million revaluation was not included in ScottishPower’s balance sheet at 31 March 1991, although it was disclosed by way of a note to that balance sheet. On this basis the gearing was 51.4 per cent.

To float the companies with these levels of gearing, the Department injected long-term debt of f284 million into ScottishPower and f228.2 million into Hydra-Electric in the form of debentures for which the companies received no proceeds. In addition, short-term debt of flog.9 million and other long-term debt of f3.8 million was imposed on ScottishPower and Hydro-Electric respectively to extract outstanding cash balances in each company.

The combination of National Loans Fund debt written off and long-term and short-term debt injected into the companies resulted in net debt written off of f417.7 million (see Figure 2).

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Figure 2: ScottishPower and Hydro-Electric debt before and after Government write-off

Outstanding National Loans Fund debt written off

SconishPower Hydra-Electric Tootal Debt Debt Debt

fmillion Emillion fmillian (508.7) (534.9) (lsM3.6)

Debt injected 393.9 232.0 625.9

Net debi write-off (114.8) (302.9) (417.7)

Source: sale prospect”s

This Figure shows that the amount of debt written ofI in net terms by the Department amounted to f417.7 million.

Negotiating the sale: profit and dividend estimates and prospects

As the two companies were to be valued by reference to their dividend yield, it was important in order to maximise proceeds for the Department to agree with the directors of the companies estimates of first year dividends, and also to agree with them statements about dividend policies and future prospects which were as positive as possible. By way of illustration, fl million of dividend is worth +Z26 million in proceeds at the offer yield of 5.1 per cent. These statements are the responsibility of the directors of the companies and are included in the prospectus advertising the companies for sale. Failure to meet these expectations and to adhere to stated policies would be seen by the market as a serious indictment of the directors, unless unforeseen circumstances arose. The directors therefore negotiated these estimates and prospect statements with the Department with the above circumstances in mind. It remained open to the Department to postpone the sale if they were unable to reach a satisfactory conclusion to these negotiations. In addition, the Department inaintained the sanction of selling only a proportion of their shareholding, whereas the directors wanted the Department to dispose of it all.

The companies were to be floated in June 1991, three months following the end of the 1990-91 financial year. The Department’s negotiations with the companies focussed on estimated profits and dividends for 1990-91, and on prospects for profitability and dividend growth over the subsequent five years. This required estimates to be made of what profits and dividends might have been for 1990-91 had the companies’ new capital structures been in place for the whole of that year. These

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estimates were referred to in the sale prospectus as pro forma estimates.

In March 1991, following protracted negotiations, agreement was reached between the Department and ScottishPower on an estimate for the prospectus of a pro forma dividend of f75 million and a statement that dividends were expected to increase in real terms. Negotiations with Hydro-Electric were concluded in April 1991 and resulted in agreement on an estimate for the prospectus of a pro forma dividend of f35 million and a statement that dividends were expected to increase in real terms.

The difficult negotiations leading up to agreement on these pro forma dividends reflected the fact that they were covered only just over two times by the companies’ pro forma profits. This cover was recognised to be at the lower end of the range likely to be acceptable to institutional investors for these companies, but the Department were advised that it would be sufficient, given the companies’ prospects.

Negotiating the sale: corporation tax losses arising out of unused capital allowances

Both ScottishPower and Hydro-Electric inherited substantial corporation tax losses from their respective predecessor boards. The losses consisted of capital allowances in respect of capital investment programmes which had been unused because the capital allowances concerned had exceeded net trading profits for the years in question. These unused allowances were available for carry- forward to later years and would have sheltered the companies’ taxable profits arising in those years, thus reducing the tax from the privatised companies.

Under the Electricity Act 1989, the Department had the power to write off all or part of these outstanding tax losses. The Department were advised that sale proceeds would not be reduced by removing these losses prior to flotation because the market would be unlikely to take account of possible tax losses in assessing dividends and yield. As is generally the case in flotations, the market would expect the dividend policies of the companies to be formulated on a cautious, long-term basis. This would reflect an expected ongoing rate of corporation’ tax, excluding the benefit of any tax losses. The Department wrote off the

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companies’ tax losses as at 31 March 1991, after allowing for offset of taxable profits for 1990-91. This balance of tax losses totalled E505 million, amounting to f280 million for ScottishPower and E225 million for Hydro- Electric. The Department did not make any projection at the time of the sale of the likely ultimate benefit to the Government from this write-off. ScottishPowertold theNational Audit Office that they currently estimate that the additional amount of tax they are likely to have to pay is approximately 675 million.

Full or partial sale

The Department had to decide before the publication of the pathfinder prospectus on 8 May 1991 (17 days prior to the announcement of the offer price) whether the sale objectives would be best met by a partial or full sale. On the basis of the progressive dividend policy they had negotiated with the companies, and assuming favourable market conditions, the Department’s advisers estimated that a partial sale of 60 per cent in June 1991 followed by a further sale in, say, 1994-96 might provide marginally higher gross proceeds than a 100 per cent sale in June 1991. On the other hand, the Department and their advisers had regard to the difficulty of predicting future market conditions, and recognised that the companies would also be facing uncertainties in the future which might influence proceeds from subsequent disposals. These uncertainties included the effect of competitive pressures in the developing electricity market, future price regulation and environmental developments, such as emission level reviews in the mid- 1990s.

The Department and their advisers also identifiedthefollowingadditionalfactorswhich pointed in favour of a full sale in June 1991:

l the existence of an electricity sector on the stockmarket, offering clear markers to help set a reliable yield for the Scottish companies;

. a full sale would enable sufficient stock to be made available to individual, institutional and overseas investors, so that price tension could be maximised;

0 United Kingdom and overseas markets were buoyant, and receptive to the sale, and the use of a back-end tender would enable the Department to benefit from any

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market rise or unsatisfied demand for shares between setting the price and the start of dealing; and

. some 3.1 million individuals had registered an interest in applying for shares and so a partial sale would have limited the extent to which the Department might achieve their objective of promoting increased individual share ownership.

On 2 May 1991 the Secretary of State decided to proceed on the basis of a full sale.

Carrying out the sale: packaged shares

The Department decided that the shares should be offered at a fixed price, the price to be the same for each company. To secure an even demand in both companies from institutional and overseas investors, shares were to be offered to these two groups of investors in the form of package units, with the ratio of shares in the package reflecting the number of shares on offer in each company.

Carrying out the sale: bookbuilding

In a fixed price offer, a crucial stage is to gauge as accurately as possible the likely level of institutional and overseas demand for the shares.

As part of that process, the Department employed a technique known as bookbuilding. This had been implemented for the first time in the sale of National Power and PowerGen. Institutional and overseas investors were asked to specify, through the Department’s brokers, in two stages in advance of the offer, how much they might be prepared to invest at a range of yields specified by the Department. These indications are not contractually binding but, on the basis of this information, shares are allocated, some provisionally, to the highest bidders.

Carrying out the sale: underwriting

Underwriting traditionally takes place in two stages. First, before the offer is announced, a syndicate of primary underwriters commit themselves to purchase the shares, if necessary, from the time the offer is announced until the sale has been completed. Second, as soon as the offer is announced, sub-underwriting is offered to institutional investors, who, upon acceptance, carry the risk until the sale is completed. In this sale, however, the Department followed the Department of Energy’s example in the sale of

12

THE SALE OF SCOTTISHPOWER AND HMRO-ELECTRIC

National Power and PowerGen in dispensing with primary underwriting, since the use of bookbuilding was expected to provide a reliable guide to the pricing of the offer at a level that would ensure a satisfactory sale. The Department also decided, again following the Department of Energy’s example, that the offer should be sub-underwritten.

2.39 Dispensing with primary underwriting meant , that the Department would bear the risk of not

securing adequate sub-underwriting and of the offer being under-subscribed. As the final

+ stage of bookbuilding was to take place two days before the offer price was announced, the risk of not securing adequate sub-underwriting was felt to be minimal as long as the results of the bookbuilding were carefully interpreted. The Department recognised, however, that bookbuilding provided no guarantee that the issue would be successfully sub-underwritten in the event, for example, of a sudden fall in the market in the period between the announcement of the offer price and securing sub-underwriting. Generally this period is no more than one day.

Carrying out the sale: back-end tender

2.40 The Department decided that, if demand was sufficient, a proportion of the shares provisionally reserved for allocation to institutional and overseas investors would be withdrawn. They would then be re-offered to these investors by way of tender after the close of the fixed price offer to individual investors, and would be allocated to the highest bidders. This arrangement, which is known as a back-end tender, had been implemented for the first time by the Department of Energy in the sale of National Power and PowerGen.

Carrying out the sale: individual investors

2.41 In line with previous flotations, the Department announced that the proportion of shares

I provisionally reserved for allocation to individual investors as a group would be increased if subscriptions from individual investors exceeded, in this case two times, the provisional allocation. In that event the proportion would be raised from 32.8 per cent of the issue to 56.2 per cent, and the provisional allocation to institutional and overseas investors would be correspondingly reduced.

2.42 This feature not only helps promote increased individual share ownership but, together with

2.43

2.44

2.45

2.46

the back-end tender which it triggers, is also designed to put pressure on institutions to accept a higher price than they might otherwise offer, as it squeezes supply.

Carrying out the sale: pricing the offer

In pricing the offer, the Department aimed to ensure that when the shares came to be traded on the stock exchange, they would command a modest premium of 5 per cent to 10 per cent on the fully paid share price [equivalent to between 12 and 24 pence a share). This was in order to secure a healthy aftermarket while at the same time not offering a premium so large as to provoke substantial oversubscription and subsequently to encourage investors to dispose of their shares in order to reap immediate gains.

The bookbuilding exercise was held in two stages (24 and 28 May), the latter stage being two days before the Department announced the offer yield and share price (30 May). At the first stage, the Department asked institutions and overseas markets to indicate their potential demand at yields ranging from 4.5 per cent to 5.8 per cent. At the second stage, the range was narrowed to 4.6 per cent to 5.4 per cent.

The second bookbuilding exercise indicated that the offer would be once covered at 4.7 per cent. The Department’s principal financial and braking advisers considered that in practice the companies would actually trade at a yield of 4.8 per cent to 4.9 per cent. They therefore advised that, in order to obtain the target premium of 12 pence to 24 pence a share, the offer should proceed on the basis of either a 5.1 per cent or 5.2 per cent yield. The Department’s advisers considered that the likelihood of the anticipated premium being eroded over the offer period was relatively low.

The Department chose 5.1 per cent, at which level bookbuilding showed the offer to be twice covered, in order to maximise proceeds and to reduce the risk of substantial oversubscription. In deciding not to price the offer at 5.2 per cent, they accepted a greater risk that the anticipated premium might be eroded over the offer period, but judged that risk to be acceptably low. The difference between selling the shares at 5.1 per cent rather than 5.2 per cent represented additional proceeds of g55 million.

13

THE SALE OF SCOTTISHPOWER AN!, HYDRO-ELECTRIC

2.47

2.48

2.49

2.50

2.51

This yield placed a value of nearly f2.9 billion on the companies. The share price, announced on 30 May, was set at E2.40, and some 1,198 million shares were made available. The ratio of shares in the package of shares in both companies was set at 68 ScottishPower: 32 Hydra-Electric.

United Kingdom institutions bid more strongly on the full range of yields than overseas investors and the Department decided to have 82 per cent of the offer underwritten by these institutions and 18 per cent by overseas investors. Figure 3 summarises United Kingdom institutional and overseas demand in the bookbuilding at these allocations. Within the overseas underwriting allocation of 18 per cent, the individual markets received: Japan 40 per cent; Europe 30 per cent; United States of America 20 per cent; and Canada 10 per cent.

Figure 3: United Kingdom institutional and overseas demand at different yields

Possible offer

yields her cent,

Demand expressed in terms of the number of times each market’s allocation was covered

UnRed Kingdom overseas Total ma&t market underwritten

4.7 1.11 0.64 1.02 4.8 1.35 1.12 1.31 4.9 1.54 1.60 1.55 5.0 1.94 2.03 1.95 5.1 2.05 2.28 2.09 5.2 2.16 2.58 2.24 5.3 2.29 2.75 2.37

Source: Sconish Office Industry Department

This Figure shows, at difkrent yields. how many times the offer was covered by bids imm United Kingdom institutions and overseas investors.

O”tcome

Between the fixing of the offer price on 30 May 1991 and the close of the offer to individual investors on 12 June there was a modest increase of about 1.2 per cent in the value of the Financial Times All Share Index.

At the offer price, demand from individual investors exceeded two times the number of shares initially allocated to this group. This level of demand triggered reallocation of 23.4 per cent of the shares to individual investors bringing their total allocation up to the envisaged 56.2 per cent. It also activated the back-end tender for a further 16 per cent of the shares.

Under the terms of the back-end tender, institutional and overseas investors were invited to submit bids by 14 June 1991 by

2.52

2.53

2.54

reference to the partly paid price of the shares (El each). The bids ranged between 101 pence and 150 pence, with an average of 123 pence. All those bidding for shares at or above 120 pence received shares at the price they bid. Japanese and European investors were the most successful bidders in the back-end tender and obtained 88.8 per cent of the shares available in the tender. The tender secured additional proceeds of fZ42.25 million.

The aftermarket

At the close of the first day’s dealing in the shares (18 June) the market valued ScottishPower at f2,082 million and Hydro- Electric at fl,005 million, an increase ofs126.3 million and f84.4 million respectively over the offer yield valuation of the companies. The closing share premiums were 15.5 pence (or 6.5 per cent of the fully paid share price) for ScottishPower and 22 pence (9.2 per cent) for Hydra-Electric, both within the Department’s ! target range of 12 to 24 pence. The upward movement in the market of about 1.2 per cent during the offer period accounted for about 3 pence of the premiums available on the first day of trading.

On the second day’s dealing Scott&Power’s shares fell just below the bottom end of the target premium range, closing.at a premium of 10.5 pence. They traded mostly below that premium for some months after the sale. Over the same period, Hydro-Electric shares traded mostly at higher premiums. Figure 4 shows that in the six months following the close of the first day’s trading the share prices of both companies reduced relative both to the electricity sector and to the market as a whole and, whilst mostly remaining above the offer price, moved below the aftermarket target premium range.

Objective (b) (ii] and (iii): promoting increased individual share ownership

In addition to achieving a healthy aftermarket, I

the Department’s objective of maximising net proceeds was subject to:

[ii) the promotion of increased individual share ownership, firstly in Scotland but also in the United Kingdom as a whole, consistent with the sales of the electricity supply industry in England and Wales: and

14

THE SALE OF SCOTTISHPOWER AND KYDRO-ELECTRIC

Figure 4: Movements in share prices (fully paid basis) from date issue was priced to 31 December 1991

Percentaoe chanoe in share orices

1 , , , / , , , , , , ( , , , , , , , , , , , , , , , , , , , , , +----- Start of trading

May 28 June 18 Aug 6 Sept 3 Ott 1 NW5 lkc 3 DE 31

Scottish Power Hydro-Electric Fl Al Share Electricity Sector

source: P”t#Shed stock Market pr,ces fe?ll at close Of trade at me end Of em week romwing the stall Of trading.

This Figure compares movements in the share prices of ScottishPower and Hydra-Electric with those of the Financial Times All Share Index and the Financial Times Index for the ekctricib sector as a whale.

(iii) the encouragement of share ownership by individual company customers and employees.

2.55 The promotion of increased individual share ownership was a key feature in the sale, largely accounting for the method of sale chosen and particularly features such as the allocation of a majority of the shares to individual applicants, and the incentives provided to encourage individual investors. The National Audit Office examined whether, in pursuit of these objectives, the Department had:

0 defined what they meant by promoting increased individual share ownership;

. considered the need for incentives for each of the groups of individual investors they wished to ateact:

. set appropriate targets at relevant stages along the road to the sale;

. adopted an appropriate allocation policy: and

. monitored the outturn.

Definitions

2.56 TheDepartmentconfirmedtotheNationalAudit Office that they wished to persuade individuals who had not previously owned shares, or if they had but no longer did so, to purchase and retain shares; and to persuade those who already owned shares to add to their portfolios by purchasing and retaining further shares. They were particularly concerned to.promote individualshareownershipinScotland:thiswas the first privatisation since the sale of British Gas which involved Scottish customers.

15

THE SALE OF SCOTTlSHPOWER AND WDRO-ELECTRIC

2.57

2.58

2.59

2.60

2.61

Customers

Market research, commissioned by the Department in 1989, indicated that potential customer investors would be unlikely to wish to take up all the shares and that up to 80 per cent of individual investor demand would cane from elsewhere.

The Department allowed customers to purchase shares in their own supplying company or a package of shares, but not both. They set the minimum level of shares customers could purchase in their supplying company at 100 to encourage applications from those who had not previously been shareholders.

Non-customers

In order to prevent over or undersubscription by non-customers, in one or other of the companies, the Department required individual investors who were not customers to apply for a package of shares. The minimum size fixed for the package was 300 shares because with ScottishPower approximately twice the value of Hydro-Electric, the Department considered that a holding of many fewer than 100 shares in Hydra-Electric would have been uneconomically small both for the shareholder and the company.

Incentives for individuals

The Department decided to offer incentives to individual investors for three reasons: to encourage individuals to register au interest in the sale; to encourage those who had registered to apply for shares; and to encourage long term shareholding. To this end, incentives were only available to applicants who had registered au interest in buying shares. To avoid adverse media comment, which might affect registration and application levels and prejudice the success of the sale in Scotland, the Department concluded that they had to offer equivalent payment terms and incentives to those offered to customers in the sale of the regional electricity companies.

In the sale of the regional electricity companies the share price of f2.40 is payable in three instalments. Customers could opt for a bill voucher of fl8 for every 100 shares purchased, subject to a maximum off 270 over two and a half years for a holding of 1,500 shares or more, or for one bonus share for

every ten shares held for a period of three years subject to a maximum of 300 bonus shares. For the present sale, the Department adopted this approach for preregistered customers buying shares in their own supplying company. In addition, they brought forward the issue of bill vouchers by three months at au estimated cost of f300,000 - f400,OOO. This was in order to compensate customer investors, in part, for the fact that their first year return was lower than the corresponding return for customer investors in the sale of the regional electricity companies because shareholders in the Scottish companies had to wait longer for their first dividend.

2.62 Customers who had registered an interest and who decided to apply for the package of shares could receive, in addition to the incentives available for shares in their supplying company, bonus shares of one for every twenty purchased and held for three years in the other company. All preregistered non-customers were eligible to receive bonus shares, up to a maximum 150, of one for every twenty purchased and held for three years.

Incentives for employees

2.63 As in previous sales, special terms were offered to employees of the companies to purchase shares to encourage them to take a stake in the future of their companies. Employees of Scottish Nuclear were able to benefit from those terms to purchase shares in ScottishPower. The employee incentives package was drawn up in consultation with the management of the companies and the employees’ trade union representatives. Employees could benefit from free and matching offers, and from discount and priority offers.

2.64 Under the free and matching offers, each 1 employee could apply for free, fully paid shares to a value of f140, and a further fz I

worth for every completed year of continuous I service. In addition, matching shares were offered whereby employees could obtain two free shares for every share purchased up to a fully paid value of f230.

2.65 Under the discount offer, each employee could purchase shares up to a fully paid value of El,250 and receive a discount of 20 per cent on that price on payment of the third instalment. Under the priority offer employees

!

16 I ,


2.66

2.67

(and pensioners) could apply for shares in their employing or formerly employing company up to the value of fl5,350 at the fully paid share price, and receive them in priority to any other applicants for shares. In sum, au employee or pensioner could, under the discount and priority offers, apply for a maximum of 6,917 and 6,396 shares respectively. Investors in the discount and priority offers could opt for bill vouchers or bonus shares.

Under the free, matching and discount offers the incentives had a maximum value of f880 for an outlay of f1,230 for au employee with 16 years service (the average for the industry). These amounts are in line with those for the regional electricity companies’s& updated by inflation, and represent a greater return to the employee than in privatisations prior to the regional electricity companies’ sale. The Department took the view that the only appropriate ccarse was to give employees in Scotland the same as their counterparts in England and Wales. Figure 5 compares the value of incentives offered to employees in the Scottish sale to those offered in certain past privatisations.

Figure 5: Employee incentives Company YMJ Value Of Personal

Incentives Investment Required

C’ r

oSritish Telecom 1984 683 2,817

aBritish Gas 1966 782 2,542 0Water Companies 1989 806 2.538 Hegional Electricity and 1990 860 1,220

Electricity Generating Companies

Scottish Electricity Companies 1991 880 1.230 Source: National Audit Office

Notes: * Maximum value of incentives based on 15 wars service. o Value at December 1990 prices.

This Figure compares the value of the incentives on of&r to employees, and the personal investments required, ior the sales of British Telecom. British Gas, the Water Companies, the Regional Eleclricity and Electricity Generating Companies and the Scottish Eleclricity Companies.

Targets: subscription and registration

In order to trigger reallocation from institutional and overseas investors to individual investors, the Department required subscription of at least two times the original level of the public offer. To allow a margin for uncertainty, the Department aimed to achieve 3 to 4 times subscription of the shares initially reserved for the public offer. They considered they would

be likely to meet this target if some 3 million individualsregistered aninterest inapplyingfor shares. In the event, they secured 3.6 million registrations and the offer was 3.2 times subscribed.

2.68 Before setting the offer yield, the Department used market research to help assess likely demand from those who had registered au interest in buying shares. They estimated that, exclusive of company employees and pensioners, individual investors were likely to account for scune f3 billion of demand, of which nearly f800 million would come from Scottish investors. In the event, after the Department had tightened the offer yield to 5.1 per cent, individual investors actually applied for nearly f 2.5 billion worth of shares of which f722 million was from investors resident in Scotland. In addition, employee and pensioner demand totalled f171 million and non- registered demand f237 million. In total, some 2.2 million individual and employee and pensioner applications were received.

Share allocation

2.69 The Department allocated shares to individuals in the following priority order: employees and pensioners; registered customers applying for shares in their supplying company either as part of the package or on an individual company basis: registered non-customers applying for shares in both companies; and non-registered applicants. The Department wished to make allocations to all customer registrants (except perhaps in response to very large applications); to make no allocation significantlysmallerthantheminimumpackage size to as many non-customers as possible: to treat equally customers in the two companies who applied for shares in their supplying company; to allocate numbers of shares amounting to no less than 5 per cent of the number applied for; and to scale back if necessary, applications from registered non- c”stomers.

2.70 In the public offer the Department allocated 10.3 per cent of the shares on offer to company employees and pensioners, who received all the shares they asked for. Customers investing in their supplying company received 35.6 per cent of the shares. Within this group, allocation was made in full to registered customers who applied for up to 2,000 shares in their supplying company (97 per cent of registered customer applicants).

17

THE SALE OF SCclTnSHPowER AND HYORO-ELECTRIC

2.71

2.72

2.73

Non-customers received 54.1 per cent of the shares on offer (see Figure 6). Within the registered non-customer group, two thirds applied for the minimum number of package shares (300). They received 250 shares. Those applying for more than 300 shares had their allocations scaled down progressively; those who applied for 1,000 shares or more, and applicants who had not registered, received nothing.

Figure 6: Share allocation lo individuals

Shares As a percentage As a percentage allocated of shares applied of shares allocated (millions) for to individuals

% %

Company Employees 67 100 10.3 and Pensioners

Customers 231 93 35.6

Non-Customers 351 45 54.1

649 100

so”,cs: sc0nk.h CJfke ,“dl&-fly Depamw”r.

Tfis Figure shows the pdoQ given first to company employees and pensioners. and second to customers applying for shares in their supplying company.

Share retention

The Department sought, as noted earlier, to manage the level of demand for shares throughbringingthe dividend yield down to 5.1 per cent. As a result, the Department were able to match allocation closely to demand: 97 per cent of those applying with customer preference received all the shares they asked for. In allocating shares largely in accordance with what had been applied for, the Department hoped that this would encourage customers, employees and pensioners to retain their shares.

Data held by the companies’ registrars at the end of December 1991 (six months after the sale) indicate that 81.2 per cent of customer, employee and pensioner shareholders still retained shares. This compares with a non- customer retention rate of 64.2 per cent. Overall, 67 per cent of all individual shareholders had retained shares at that date.

The Department have not conducted any market research into the reasons why smne individuals have sold their shares in the two Scottish electricity companies while others have retained them. The National Audit Office note that in the first six months following the sales of the regional electricity companies and theelectricitygeneratingcompanies, individual shareholder retention rates were respectively 40 per cent and 54 per cent.

2.74

2.75

2.76

2.77

In the first six months following flotation, share premiums as well as disposal rates were low. Premiums in this period for ScottishPower ranged between 19% pence and a discount of 5 pence: Hydro-Electric premiums ranged between 24 % pence and a discount of %p. The range in the equivalent period for the regional electricity companies was 34 % pence to 170 pence. For the electricity generating companies the equivalent range was 10 pence to 71 ‘/z pence. In the absence of research following the sale, it is a matter of speculation I how far there is a link between the level of share premiums and disposal rates or whether other factors, for example, allocations closely matching demand, and customer loyalty, may also be relevant.

In the period following flotation to the end of December 1991, individual customers, employees and pensioners Who sold shares, had sold. on average. 1.203 shares each. Figure 7 shows that, overall, 9.8 per cent of customers, employees and pensioners were allocated over 1,000 shares each. These allocations accounted for smne 42 per cent of the total allocations to customers, employees and pensioners.

Data provided by the registrars suggest that most disposals were probably made by those employees and pensioners who were allocated more than 2,000 shares. Allocations to these groups accounted for scame 21.5 per cent of the total allocations to customers, employees and pensioners. By the end of March 1992, the number of employee and pensioner shareholders of ScottishPower continuing to hold more than 2,000 shares had reduced by 78 per cent. The corresponding figure for Hydro-Electric was 50 per cent. By contrast, the number of customer and other employee and pensioner shareholders continuing to hold fewer than 2,000 shares by that date had reduced by a lower percentage: 28 per cent for ScottishPower and 21 per cent for Hydro- Electric. ’ j

i It seems likely that the relatively high overall level of retention (81.2 per cent) by customers, employees and pensioners, at the end of the six months following the sale, was influenced by low premiums, and that low premiums generally made it profitable only for those with large allocations to sell. Individuals selling shares will generally be liable to pay commission to selling agents. Commissions vary but a flat rate charge of about f15 was I

I

18

THE SALE OF SCOTTISHPOWER AND KYDRO-ELECTRIC

2.78

Figure 7: Share allocations to customers, employees and pensioners by size of holding

Number of Shares Number of Employees

Allocated Customers & Pensioners To& %

96-500 327,405 2,006 329,413 69.9

501-1000 93,798 1,743 95,541 20.3

1001-2000 35,915 567 36,482 7.7 9.6

2001-6917 9,953 9,953 2.1 > Total 457,118 14.271 471,389 100.0

Source: Scottish Office Indusby Department

Note: This Figure excludes free and matching shares allocated to employees, which are initially held in tnM and cannot be sold for a limited period, and shares held by customer of one comoanv in their non-suoolvino comoanv.

This Figure shows the number of customers, employees and pensioners allocated shares in their supplying or employing company. by size of holding.

available. On this basis an individual selling 500 shares will break even at a premium of 3 pence; selling 1,000 shares, he breaks even at a premium of 1% pence; and selling holdings of 1,500 shares and above, he breaks even at a premium of lp.

It also seems likely that low premiums combined with small shareholdings played a part in the fact that, six months after the sale, 64.2 per cent of non-customers still retained shares. For example, by the middle of March 1992 Hydco-Electric still had some 780,000 non-customer shareholders in England and Wales with less than 100 shares each, in accordance with the terms of the share package for which they applied. The company told the National Audit Office that this represented a significant administrative cost to them and that they were actively encouraging such shareholders either to increase their holdings or to sell them.

2.79 The Department question whether they would have obtained value for money by commissioning market research into share retention patterns after this privatisation. In the view of the National Audit Office, however, such research in the period immediately following the sale might have provided useful information on key factors influencing investors’ buying, selling and retaining decisions in the particular circumstances of this sale. These factors include the impact of advertising, incentives, media comment and the expected and actual level of the aftermarket premium. The results of this research might also be of assistance to departments in planning future sales. The Department argue, however, that it would be a matter for departments planning future sales to carry out any such research if this were thought to represent good value for money.

19


Part 3: Control of costs

3.1

3.2

Overall costs

The Department estimate that the net costs of the sale, excluding their own staffing costs, value added tax and stamp duty, will amount to E98.0 million [Figure 8). This represents some 2.8 per cent of gross proceeds. It includes an estimate of the costs of incentives for individual shareholders.

Financial control and project management

The National Audit Office examined whether the Department had: l prepared a project plan by reference to

which they allocated resources and monitored progress towards targets; and

. identified their external advice requirements and followed appropriate procedures in their appointment of external advisers.

Figure 8: Estimated proceeds and costs of the sale

f E million million

Value of shares offered for sak Add: prmeds from h.sC!w”d tender Less: proceeds forgone by way of incentives

Employees’ free and matching shares and discount lg.7 Individual investors’ bonus shares 52.9

Equity proceeds

Less: other costs as follows: Undenwiting 21.5 Selling and braking commi%ion 4.1 Receiving Banks, printing and other logistical costs 29.4 Markettng costs 5.8 UK Advisers fees 19.6 oveneas costs 9.1 Less interest on application money .pl

98.2 Incentives for individual shareholders 9.8

Net costs of the sale

Net proceeds from sale 01 shares Proceeds from repayment of debt

Estimated total net proceeds

2.975.9 42.2

63.5

2.854.5

98.0 - 2,756.5

625.9

w2.4 -

Source: Scottish Office bdosfry Department estimaied 00num as at 31 March 1992

This Figure shows estimated proceeds, costs and total net proceeds from the gale of ScoibshPower and Hydra-Electric.

3.3 The Department’s financial advisers (Barclays de Zoete Wedd and British Linen Bank) prepared a detailed plan of the tasks necessary to complete the sale. Monitored by the Department, they set up a number of working groups for particular areas of the plan. These groups comprised representatives from the relevant advisers, the Department and, as appropriate, the Treasury and the companies themselves. The Department’s representation on the various working groups allowed them to ensure that satisfactory progress was being made in all areas of the sale.

3.4 The Department employed 33 principal advisers and contractors for the sale (Appendix 3). The Department’s appointments were based primarily on their assessment of the quality of service offered, but regard was also had to price. Five advisers were not appointed on a competitive basis: these advisers were already working for either the Government or the companies in an advisory capacity (for example, as valuers or auditors) and were judged to have given satisfactory service. Treasury approval was given for the appointment by single tender of these five advisers.

Marketing

3.5 The National Audit Office examined whetha the Department had:

. adopted a strategy that was appropriate to the particular requirements of the Scottish sale; and

.’

. appraised the effectiveness of this j

strategy in meeting its targets.

Target audience

3.6 In May 1989 the Department commissioned market research to determine the level of likely demand for the offer from residents in Scotland, England and Wales. This research indicated that sane 80 per cent of total demand from individuals was likely to come

20 ,

THE SALE OF SCOTTBWOWER AND HYDRO-ELECTRIC

from investors who had bought shares previously, with almost half of this demand from residents in London and the South East of England. Given, however, the Department’s objective of promoting increased individual share ownership, particularly in Scotland, the Department sought to maximise Scottish demand by targeting its campaign on all adults there. The Department were advised that to campaign as extensively in England and Wales would be prohibitively expensive and unnecessary. Instead, the Department targeted its campaign in England and Wales on those residents most likely to invest in the sale. The Department were advised that these potential investors tended to be mainly resident in southern England.

Coordination with the sales of the regional electxicity companies and the generators

3.7 The primary task for the Government, the industry and their advisers was to ensure the successful flotation of tbe whole of the non- nuclear electricity supply industry. To achieve this it was important to ensure that the individual marketing initiatives for each of the three sales were complementary and in the best interests of the industry as a whole. To this end the Treasury produced guidelines for the management of a coordinated marketing timetable in order to prevent any conflict between the campaigns. In addition, the respective advisers of the Department and of the Department of Energy coordinated their advertising campaigns.

Marketing strategy

3.8 The Department’s marketing strategy comprised three separate campaigns: an initial corporate awareness campaign, a further corporate awareness campaign nearer to the time of the sale, and an offer campaign.

3.9 The objective of the two corporate awareness campaigns was to raise the target audiences’ awareness of the identity and functions of the two companies and of the forthcoming sale, and to foster positive attitudes to the Scottish electricity industry. To avoid overlap with the sales of the regional electricity companies and the generators the campaigns ran intermittently from late April 1990 until March 1991.

3.10

3.11

3.12

3.13

3.14

The Department launched their offer campaign in March 1991. This campaign had two main objectives: first, by creating and developing awareness of the offer and its timing to encourage individual investors to register an interest in the offer; second, to convert the maximum number of registrants into applicants. The Department set themselves the target of obtaining three million registrations. They estimated that, based on experience from previous privatisations, this number of registrations would be sufficient to ensure that the offer was fully subscribed by individual investors.

The Department used a combination of advertising [television, press and posters) and media information campaigns in order to communicate their marketing message. In addition, at the Department’s request, the Chairmen of the companies sent a mailshot to each of the companies’ customers to inform them of the forthcoming sale and to invite them to pm-register. A mailshot was also sent to individuals resident elsewhere in the United Kingdom who had applied for shares in the regional electricity companies.

outcome

The Department achieved their target level of registrations within five weeks of the beginning of the eleven week offer campaign. To discourage further registrations and thereby prevent possibly substantial oversubscription of the offer, the Department cut back on their level of television advertising.

By the end of the offer campaign, the Department had received some 3.6 million pre- sale registrations. Market research commissioned by the Department in May 1991 indicated that some 54 per cent of these registrants were likely to apply for shares. In the event, the market research proved accurate since nearly 2 million registrants (54 per cent) applied for shares.

Marketing costs

The Department estimate their marketing costs to be 25.9 million (excluding value added tax). This represented savings of around fl.2 million compared with budget. Most of this saving arose in the areas of television advertising and television production.

21

THF. SALE OF SCOTTISHPOWER AND HY!XRO-ELECTRIC

Underwriting costs Cost of incentives

3.15 The National Audit Office estimate that the Department saved around f3.8 million in

3.16 The Department allocated free and matching

commission through dispensing with primary shares and estimated discounts to employees

underwriting. Having regard to their decision to a value of f10.7 million, and initially

not to seek primary underwriting, the expected a maximum bill voucher liability of

Department decided not to seek sub- f14.9 million and a maximum issue of bonus

underwriting fees lower than had been paid in shares to a value of f84.7 million. At 31 March

connection with the sales of the regional 1992 the Department’s liability for bill voucher

electricity companies and of the electricity expenditure stood at f9.8 million and for the

generating companies. They paid United provision of bonus shares at f52.8 million.

Kingdom institutions sub-underwriting commission of 1.25 per cent of the offer price, and overseas institutions 1.2448 per cent.


Glossary of terms

Aftermarket

Capital allowances

Debt injection

Distribution

Dividend cover

Financial Times All Share Index

Flotation

G-3l~ldiO*

Interest CoYer

Offer price

Premium (discount)

Privatisation

Pro forma estimates

Public offer

Receiving banks

Selling agents

Subscription

SUPPlY

Transmission

Underwriting

Yield

The period following the start of dealing in shares newly issued on the London Stock Exchange.

Allowances designed to give tax relief for capital depreciation of business assets.

Debentures issued to HM Treasury, repayable over various periods, for which the cornpanics rcccivcd no Proceeds.

The local iansport and delivery of electricity at less than 132 kilovolts. Most customers receive their electricity at 240 volts.

A measure of the safety of the dividend, normally obtained by dividing the profit available for distribution by the net dividend to be paid.

An index of the share values of some 850 companies quoted on the London Stock Exchange, accounting for more than 90 per cent of the value of all listed shares.

The sale to individuals or institutional investors of shares which can then be traded on a market.

The production of electricity.

Profit before interest and tax divided by interest payments.

The price at which shares about to be issued are offered for sale.

The amount by which newly-issued shares are traded on the London Stock Exchange above (below) the issue price.

The sale to the private sector of assets owned by the state.

In this case, estimates of 1990-91 profits and dividends on the basis that the companies’ new capital structures had been in place since 1 April 1990.

Sharesprovisionallyallocatedtoindividualinvestors,whichmaybeincreasedinnumberif demand from individuals exceeds a specified level of subscription.

Banks commissioned by the Department to receive and process applications made by or on behalf of individual investors.

Financial advisers who acted on behalf of individual applicants and were enabled to claim commission from the Department.

The total number of shares applied for in relation to the total number on offer.

The acquisition of electricity and its sale to customers.

The bulk transfer of electricity across the country at high voltages.

An agreement under which, in return for commission, financial institutions agree in advance to buy unsold shares. There is primary underwriting and sub-underwriting.

The expected annual income return to shareholders from dividend payments, expressed as a percentage of the full share price represented by the gross dividend.

23

THE SALE OF SCOTTLWFOWER AND HYDRO-ELECTRIC

Appendix 1 Electricity Industry restructuring in Scotland

Electricity industry before restructuring

1 This Appendix outlines the main changes to the electricity industry in Scotland provided for in the Electricity Act 1989.

2 Before 31 March 1990, the supply of electricity in Scotland was the responsibility of two regional boards, the South of Scotland Electricity Board (the South Board) and the North of Scotland Hydro-Electric Board (the North Board). Each board was vertically integrated, that is to say they generated, transmitted, distributed and supplied electricity, between them serving the whole of Scotland and part of Northumberland.

3 The two boards had a different mix of generating plant and served was with different demographic and geographic characteristics. The South Board’s area was characterised by large densely populated urban areas, whereas the area served by the North Board was more widespread and sparsely populated. The vast majority of the South Board’s generation capacity was derived from fossil fuels and nuclear energy, whereas most of the North Board’s capacity came from hydra and pumped storage generation. Scotland has a substantial surplus of generating capacity, with some 11.6 gigawatts of output capacity against a combined peak demand of some 5.5 gigawatts [a gigawatt = one thousand million watts).

white Paper “Privatisation of the Scottish Electricity Industry”

4 In March 1988, the Government published a White Paper (Cm 327) setting out the proposals for the privatisation of the electricitjr industry in Scotland. The White Paper proposed that the South and North Boards be privatised as two separate companies, each having a mix of generating capacity and access to the capacity of the nuclear generating stations, then owned by the South Board, which were to be transferred to a company jointly owned by these companies. In November 1989, however, the Secretary of State announced that this jointly owned company (Scottish Nuclear) would remain in publicownershipandwouldsupplyelectricitytoScottishPowerandHydro-Electric.Under the subsequent Nuclear Energy Agreement, which expires in April 2005, ScottishPower and Hydra-Electric are obliged to take 74.9 per cent and 25.1 per cent respectively of the electricity which Scottish Nuclear declares it can generate from its nuclear stations at Hunterston and Torness.

5 Each company would have the monopoly of tmnsmission and distribution of electricity within its own area. It would also have the monopoly of the supply of electricity within this area, except that the two companies would be able to compete with each other, and with new entrants to the electricity generation market, for the supply of electricity to large commercial customers in Scotland (ie those with peak demands of 1 megawatt (1 million watts) or above until 31 March 1994, falling thereafter to 100,000 watts until 31 March 1998). The two companies would be able to export electricity to England and Wales where they would be in competition with other generators and suppliers. Customers’ interests were to be protected by regulation.

6 The Electricity Act 1989 made provision for these proposals to be given effect.

24


Regulation 7 Regulatory control of the two Scottish companies is provided by the Office of Electricity Regulation (OFFER), which was established in September 1989. OFFER is headed by the Director General of Electricity Supply and in Scotland by the Deputy Director General of Electricity Supply. The Deputy Director General’s primary tasks are to ensure that power supplies are secure, to promote competition, to protect the interests of consumers, and to ensure adherence to the terms and conditions under which electricity is generated, distributed and sold to consumers. The transmission, distribution and supply of electricity by the two companies are subject to price controls, based on the retail prices index, prescribed by the Director General of Electricity Supply.

25


Appendix 2 The map below shows the approximate locations of the authorised supply areas of ScottishPower and Hydro-Electric:-

Shetland

ScottishPower


Appendix 3 Principal Advisers and Contractors appointed by the Department

Adviser/Contractor

Coopers & Lybrand

Faulds

De Zoete and Bevan

Bell Laurie White

BMO Nesbitt Thomson

Osler Renault Ladner

Royal Trust Company

Tayburn Design

Credit Suisse First Boston

Barclays de Zoete Wedd

British Linen Bank

Price Waterhouse

Daiwa

Hamada and Matsumoto

Willis Wrightson

McGrigor Donald

Citigate Communications

PR Consultants Scotland

British Market Research Bureau

BPCC Oyez Waterlow Ltd

National Westminster Bank

Royal Bank of~scotland

Bank of Scotland

Area of work

Accountancy and Regulation

Advertising Agency

Brokers

Brokers

Canadian Financial

Canadian Legal

Canadian Registrar

Design Agency

European Financial

Financial

Financial

Fraud/Systems Auditors, share allocation modelling

Japanese Financial

Japanese Legal

Insurance

Legal

Marketing and public relations

Marketing and public relations

Market Research

Printers

Receiving Bank

Receiving Bank/Registrar

Receiving Bank/Registrar

27

THE SALE OF SCOTTKHPOWER AND HYDRO-ELECTRIC

Adviser/Contractor

Deloitte Haskins & Sells

KPMG Peat Marwick McLintock

HP: ICM

British Telecommunications (BT)

Mail Marketing

Merz and McLellan

Bank of New York

Salomon Brothers

Sullivan and Cromwell

Jones Lang Wootton

Area of work

Reporting Accountants

Reporting Accountants

Roadshow Contractor

Share Information Office

Share Information Office

Technical

US Depository Bank

US Financial

us Legal

Valuation

28

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